AP, IB, and College Microeconomic and Macroeconomic Principles 

6 Things To Know About Gross Domestic Product

6 Things to Know About GDP by Test Day

Updated 10/13/2021 Jacob Reed
Below you will find a rundown of everything you need to know regarding Gross Domestic Product (GDP). When you are done reviewing, head over to the 25 question flash review game to test your skill identifying components of the output expenditure model of GDP.

Circular Flow Diagram

1. What is GDP? 
GDP or Gross Domestic Product is the total value of all new goods and services produced within a country during a calendar year. It is a way of calculating all of the economic activity in the circular flow model of the economy. Another way of looking at it is that GDP is a measure of an economy’s creation of wealth. On the Advanced Placement (AP) Macroeconomics Exam, GDP is synonymous with Income (abbreviated as Y) and Output.

Per capita GDP (GDP divided by the population) is often used as a measure of a country’s standard of living. When a country’s per capita GDP increases, economists expect the standard of living for that country’s citizens to increase as well, as there is more wealth created per individual.

2. What is counted in GDP?
In order to be counted in GDP, a good or service must be brand new. It must be a final good meaning it is not part of or consumed in the production of another good or service. Also, the product must be made within the country’s borders (the nationality of the producer does not matter). 

3. What is not counted in GDP?
Intermediate goods are goods which go into the production of some other good. Rice in the production of sushi rolls, for example, is an intermediate good. The final sushi rolls will be counted in GDP but the rice will not. Another example is gasoline used by a taxi driver. The taxi driver’s services will be counted in GDP, but the gasoline will not.

Used products are not counted because those products were already counted when they were new. So used cars, or sales from thrift shops are not counted in GDP.

Financial transactions are not counted because there is no good or service being produced. Purchases of stocks, bonds, etc. shuffle money around an economy but since they are not goods or services, they are not counted. 

4. How is GDP Counted?
There are three methods for calculating GDP and they relate to the circular flow diagram of the economy;  output-expenditures, the value added approach, and the income approach.The first two methods track economic activity through the product market and the third tracks economic activity through the resource market.

For the Advanced Placement (AP) Macroeconomics Exam, the output expenditure method for calculating GDP is most important. It adds up the spending within the economy on all new domestically produced final goods and services. The Value Added approach calculates GDP by adding up the contributions an economy’s firms make to the final value of new goods and services. The income approach adds the wages, rents, interest, and profit paid for resources in the economy.

5. What is the Output Expenditure Model?
The formula: C+Ig+G+Xn = GDP

Personal Consumption Expenditures (C) is the first variable in the equation. These are all the consumer purchases of goods and services. Things like shoes, cell phones, cars, milk, haircuts, and maid services are counted here.

Gross investment (Ig) includes purchases of physical capital (tools, machines, factories, etc.), residential structures, and changes in inventories. Gross investment included firms purchasing hammers, robots, building new restaurants, etc. and the value of products produced but not yet sold (a change in business inventories). Sudden increases in business inventories are often an indication of a coming economic contraction. 

Note: when changes in interest rates impact gross investment the focus is how that changes the quantity of physical capital being purchased in the economy which impacts the economy’s growth rate.

Government Purchases (G) include spending by the government (Federal, State, and Local) where the government receives a good or service in exchange for the money spent. So it counts highways, schools, tanks, teachers, police officers, etc. It does not count transfer payments where the government spends money but does not receive a good or service in return; like grants, social security payments, or unemployment compensation.

Net Exports (Xn) is the final variable in the output expenditure model. You may see Xn as (X-M). Net exports is exports (X) minus imports (M); or the value of all goods produced within this country but sold in another country minus the goods produced within another country but sold in this country.

6. Why isn’t GDP a perfect measurement of standard of living?
GDP is often used as a measurement of a country’s standard of living, but this measurement is not perfect as it can both overestimate and underestimate the true standard of living for people within an economy.

The Underground Economy is the economy where goods and services are exchanged but no one is keeping track or reporting transactions to the government. Illegal transactions like drug sales are not counted but neither are under the table transactions like a teenager getting paid to babysit for a night. This economic activity isn’t counted and so GDP underestimates economic activity.

Non-market activity, or home production, is not counted in GDP and causes it to underestimate standard of living. If people grow their own food, sew their own clothes, or fix their own cars, they have increased their standards of living and produced something, but that production won’t be counted in GDP because the production was not bought or sold.

Bad counted as Good is another problem that causes GDP to overestimate a country’s standard of living. The money spent on cleaning up pollution or rebuilding after a natural disaster is counted in GDP. As a result, pollution and natural disasters may appear to increase standards of living if GDP is the only indicator being looked at.

Distribution of Wealth is the final imperfection of GDP. GDP is a measure of wealth creation within a country, but the measurement does not give any indication as to who is receiving that wealth. GDP gives no indication of the income gap. To see who is benefiting from the new production, looking at the Lorenz Curve or Gini Coefficient can help. 

Up Next: 
Review Game: Fisher Formula
Content Review Page: GDP Deflator and CPI

Other recommended resource: Marginal Revolution University